While investors normally applaud increases in wages, as this does indicate a growing economy, Morgan Stanley analysts are concerned that this may even contribute to a recession.
Seeing both a growth in jobs and a growth in wages is something that investors find pretty appealing, as these are inflationary pressures that stimulate economic growth. The only real worry with this is usually this causing the Federal Reserve to increase interest rates to look to slow this down and therefore keep inflation more in check.
While wages have been rising for a while now, along with the total cost of wages including new jobs created, we at least aren’t seeing a rise of enough significance to prompt the Fed to take countermeasures to slow it down. Investors love growth, but they end up not liking too much of it, not because of the growth itself, which is bullish, but from it being counteracted too much by rate increases.
As long as the wage increases result from the free market, where employers pay more out of their own free will, we really don’t have to worry about this being a recessionary influence. The labor market itself sets the price here, aside from the role of non-market forces such as minimum wage requirements, but unless we get widespread increases, this has a minimal impact upon wage growth.
Whenever the labor market grows, there is a certain lag between the higher wages that get agreed on and a company’s later profit margin. These higher wages do have to make it to the market to exert their force upon prices, but companies can anticipate and plan for this, taking things like overall economic growth and inflation into account when doing so.
Earnings reports provide hard numbers from the previous period, and therefore do not benefit from this compensation. When a company projects ahead, they can account for this, but what just happened will not.
Wages going up can therefore affect the current earnings of a company, and this is actually one of the reasons why we want to keep things like this which are inflationary in check well enough. If we imagine a 100% a year rate of wage growth, with inflation rates to match, this lag has a much bigger impact upon profits and can be so large that it can become unmanageable if our predictions are off enough, and there being a bigger margin for error is the issue.
Companies may then not be able to make up the difference with their current margins and will lay people off to compensate. This has downward pressure upon the labor market, and while this will all settle in time, until it does, this can affect company profitability.
Wage Growth is Actually Not Abnormal
We don’t have anywhere near this much wage growth, which is around 3% these days, just a little higher than our inflation rate. This involves a much smaller magnitude of effects from the lag involved, and not ones that we really need to be concerned about.
There are some people who are becoming concerned though, as they are looking at reduced earnings growth, increased wage costs, shaking it all up in a cup, and pouring it.
This does start with the companies, who may tell us that their earnings are reduced because of this. While earnings do go down when you have higher costs, all things being equal, we need to drill deeper and discover what contribution higher wages are having, and not just express this concern as a full or even primary explanation.
The way that this is usually put is that higher wages have a negative impact upon earnings, and they really do, but whether this is something we even need to be concerned about or not is the real question here.
The earnings results are what they are though, and if they are lower, and are even trending down, that’s an issue that may concern us. The reasons behind it are secondary, and although we do want to look deeper into its causes, which can provide some insight, but this is not a difficult thing to measure. You just take the increase in labor costs and compare with overall profit and can get a percentage of the change that wages may be held as an explanation for.
Wages always go up, unless we are in a recession or depression, and even recessions don’t usually cause this since they are so short and the deflation is so modest. The Great Recession for instance only had us down 0.4% at its worst, nowhere near enough to put enough downward pressure on wages to make a real difference.
If we’re claiming that these wage increases will somehow have a recessionary effect, causing or contributing to one, that’s just how these forces work, even though they may cause a minor and temporary decrease in earnings.
Morgan Stanley Predicts an Earnings Recession, and Perhaps a Real One
Morgan Stanley has become concerned enough about this that they are not only telling us that this will be bearish for stocks, but it may even lead to our entering a recession, if enough people get laid off by employers who can no longer afford to pay them.
It is a given that wages impact earnings, but if we’re going to claim that this will matter so much, we have to get clear on how much this is really bringing down the water level for business. We do know that these wage increases are not that noteworthy and are not at a level that the Fed is concerned about at all, and it’s their business to become concerned when it’s actually time to.
The Fed is known for not being shy at all to raise rates if they think that it is justified, and we don’t have to look any further back than last year to get a feel for this. Many believe that the Fed was over-aggressive with these rate hikes, and it’s actually hard to argue otherwise, but their guns just aren’t strapped in as tight as they should be at times.
Morgan Stanley does understand that rising wages aren’t the whole story here by any means, and in a report released on Monday, remark that “sustained wage pressures and slowing top line growth create a dangerous recipe for margins.” We at least have two things to talk about, wages going up and growth diminishing, and a resulting loss of earnings growth, but this really doesn’t tell us how much these wage increases are impacting things.
Morgan Stanley is predicting an “earnings recession” from this, although we’re nowhere near any such a thing now. They do point out that while wages have only gone up by 3.2%, it’s the overall compensation that matters, and this is certainly true.
This is not something we talk about that much generally, but it’s overall compensation that matters, and there’s more to this than just the wages. Other costs, especially the cost of benefits, comprise a significant part of this, and if that part is going up too much, this should at least attract our attention.
Once again though, this is all determined by the market ultimately. A company will have a certain compensation capacity, and unless the labor market is shrinking, higher wages mean higher capacity. Our labor market is expanding though, so it’s not that the supply of labor is decreasing, and when the price goes up and it does not, this can only mean that demand is increasing.
This is a healthy situation even though it may have an impact upon profits. If companies end up making errors and over-extending themselves, they will adjust to more comfortable levels.
Rising wages and an economic slowdown will leave us with a temporary imbalance though, when what we expect in growth gets diminished, because this has foreseen a higher level of capacity than currently exists, with the difference representing the real shrinkage.
We need to view all of these things in perspective though, and we may then wonder how such a small difference in economic expectations could make a substantial difference.
We won’t ever get put into a recession by the value of anything going up, especially wages, or overall compensation for that matter. It’s the total compensation paid, or total wages paid as a proxy for this, that matters as far as inflation is concerned, and when this goes up, this is sufficient in itself to produce positive inflation and push us away from a recession.
This is the case even though people save more of this extra money, as is claimed. Some is spent, a good part of it actually, and this spending does positively influence both growth and inflation.
Declining earnings are a concern, the declining growth of the economy is a concern, but modest wage increases within the normal range really aren’t. When it’s the companies that are blaming this so much though, we need to realize that companies do look to spin these things and this all doesn’t hold up that well to scrutiny.